Articles - If Climate Scenarios capture risks how can they be useful


Earlier posts in this series have highlighted that current climate scenario modelling does not fully capture the risks of climate change, but rather imagines what scenarios that did capture those risks would look like. This post focuses on how asset owners might use climate scenarios in light of these considerations. The purpose of climate scenario modelling should be to drive better risk-oriented actions.

 By Sanjay Joshi, Consultant at Hymans Robertson

 Under many approaches to risk management, we are trying to do something like this:
 Get a good understanding/insight about the risks, perhaps using relevant data
 Use that data/insight to enable you to take action to avoid or mitigate the risk

 However, this doesn’t work so well with the extreme/tail risks which the earlier blog posts referred to. While we know that climate change makes extreme/tail events more likely, we don’t know which events will strike, and so we don’t know how to avoid those risks.

 Nonetheless, understanding extreme/tail risks is still action-relevant and useful. The most useful action that can be taken is to stop the worst outcomes from happening in the first place, rather than trying to dodge the worst effects when they do arise.

 Let’s consider the risks of the food systems shock that we outlined in our previous post. Such a shock could have negative implications for investors. Here’s a few examples of ways that investors could make themselves (and the world) safer from the risks of food shocks:

 Invest so as to drive forward new types of crops which are more resistant to weather events or other shocks. For example, a new type of wheat developed[1] by Norman Borlaug in the middle of the twentieth century is reputed[2] to have saved 1 billion lives.

 Invest in innovative capital markets solutions which provide governments with finance conditional on there being a food systems shock.

 As alluded to in the earlier post, investing so as to reduce the extent to which the climate warms will also reduce the risk of shocks to the food system.

 Starting from the consideration of narrative climate scenarios and having identified the potential financial risks, we are then using the scenario as a means of generating investment ideas focused on achieving real world changes. This is different from the ESG integration which currently happens in many asset owner institutions today.

 There are some who are sceptical about whether investors are able to achieve positive impact, except to a trivial degree. At first glance it may seem that these doubts must be misguided, after all risks such as climate harms arise because companies seek to maximise profits without incorporating externalities. They do this in order to satisfy investors, so it would be surprising if investors were unable to influence the outcomes.

 However, such concerns are reasonable, since attempts to achieve impact can fail in many ways. For example:
 An investor may conduct stewardship actions which aim to stop a company from performing negative/harmful activities. There’s a risk these activities could be displaced through a “whack-a-mole” effect, meaning that another company undertakes the harmful activities instead (unless prevented by regulation).
  
 An investor may invest in a company doing positive/beneficial activities. The act of investing in a company isn’t always additional; it’s hard to know whether those activities would have happened anyway, even if you hadn’t invested.

 A full treatment of these considerations is outside the scope of this post, but it’s fair to say that these concerns can be overcome, at least to some extent, and some of the time.

 Strong impact actions could be also consistent with – or even required by – fiduciary duties. A PRI report on the legal framework for impact states that if a sustainability factor (such as climate change) “poses a material risk to [the asset owner’s] ability to achieve its financial investment objectives, it will have a legal obligation to consider what, if anything, it can do to mitigate that risk”.

 This highlights the importance of this subject. Although climate change may appear not to be material based on the models we’ve been using, in fact it may be hugely material. And if that’s the case, asset owners would be failing if they didn’t consider whether they could mitigate the risks of climate change by taking strong impact actions.

  

 [1] More information about his work on dwarf wheat can be found here: Scientific American and Nobel Prize website

 [2] Some sources for the claim that Borlaug’s work saved 1 billion lives: Adam Smith Institute, Agbioworld, University of Minnesota, Guardian

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